Revision 2 Decision Making Techniques

I. CVP Analysis

Question 1
JK Limited has prepared a budget for the next twelve months when it intends to make and sell
four products, details of which are shown below:

Sales in units (000) Selling price per unit Variable cost per unit
Product $ $
J 10 20 14.00
K 10 40 8.00
L 50 4 4.20
M 20 10 7.00

Budgeted fixed costs are $240,000 per annum and total assets employed are $570,000.

Required:

(a) Calculate the total contribution earned by each product and their combined total
contributions; (2 marks)
(b) Plot the data of your answer to (a) above in the form of a contribution to sales graph
(sometimes referred to as a profit–volume graph) on the graph paper provided;
(6 marks)
(c) Explain your graph to management, to comment on the results shown and to state the
break-even point; (4 marks)
(d) Describe briefly three ways in which the overall contribution to sales ratio could be
improved. (3 marks)
(Total 15 marks)

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Question 2
PE Limited produces and sells two products, P and E. Budgets prepared for the next six
months give the following information:
Product P per unit Product E per unit
$ $
Selling price 10.00 12.00
Variable costs: production and selling 5.00 10.00

Common fixed costs: production and selling for six months $561,600.

Required:

(a) State what the break-even point in $s will be and the number of each product this figure
represents if the two products are sold in the ratio 4P to 3E; (3 marks)
(b) State the break-even point in $s and the number of products this figure represents if the
sales mix changes to 4P to 4E (ignore fractions of products); (3 marks)
(c) Advise the sales manager which product mix should be better, that in (a) above or that
in (b) above, and why; (2 marks)
(d) Advise the sales manager which of the two products should be concentrated on and the
reason(s) for your recommendation assume that whatever can be made can be sold, that
both products go through a machining process and that there are only 32,000 machine
hours available, with product P requiring 0.40 hour per unit and product E requiring
0.10 hour per unit. (2 marks)
(e) You are required to compare and contrast the usefulness of a conventional break-even
chart with a contribution break-even chart. Your explanation should include illustrative
diagrams drawn within your answer book and not on graph paper. (5 marks)
(Total 15 marks)

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Question 3
A local authority, whose area includes a holiday resort situated on the east coast, operates, for
30 weeks each year, a holiday home which is let to visiting parties of children in care from
other authorities. The children are accompanied by their own house mothers who supervise
them throughout their holiday. From six to fifteen guests are accepted on terms of $100 per
person per week. No differential charges exist for adults and children.

Weekly costs incurred by the host authority are:

$ per guest
Food 25
Electricity for heating and cooking 3
Domestic (laundry, cleaning, etc.) expenses 5
Use of minibus 10

Seasonal staff supervise and carry out the necessary duties at the home at a cost of $11,000 for
the 30-week period. This provides staffing sufficient for six to ten guests per week but if
eleven or more guests are to be accommodated, additional staff at a total cost of $200 per
week are engaged for the whole of the 30-week period.

Rent, including rates for the property, is $4,000 per annum and the garden of the home is
maintained by the council’s recreation department which charges a nominal fee of $1,000 per
annum.

Required:

(a) Identify and discuss briefly five assumptions underlying cost-volume-profit analysis.
(10 marks)
(b) Tabulate the appropriate figures in such a way as to show the break-even point(s) and to
comment on your figures. (8 marks)
(c) Draw, on the graph paper provided, a chart to illustrate your answer to (b) above.
(7 marks)
(Total 25 marks)

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II. Linear Programming

Question 4
Cut and Stitch (CS) make two types of suits using skilled tailors (labour) and a delicate and
unique fabric (material). Both the tailors and the fabric are in short supply and so the
accountant at CS has correctly produced a linear programming model to help decide the
optimal production mix.

The model is as follows:

Variables:
Let W = the number of work suits produced
Let L = the number of lounge suits produced

Constraints
Tailors’ time: 7W + 5L ≤ 3,500 (hours) – this is line T on the diagram
Fabric: 2W + 2L ≤ 1,200 (metres) – this is line F on the diagram
Production of work suits: W ≤ 400 – this is line P on the diagram

Objective is to maximise contribution subject to:

C = 48W + 40L

On the diagram provided the accountant has correctly identified OABCD as the feasible
region and point B as the optimal point.

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Required:

(a) Find by appropriate calculation the optimal production mix and related maximum
contribution that could be earned by CS. (4 marks)
(b) Calculate the shadow prices of the fabric per metre and the tailor time per hour.
(6 marks)

The tailors have offered to work an extra 500 hours provided that they are paid three times
their normal rate of $1.50 per hour at $4.50 per hour.

Required:

(c) Briefl y discuss whether CS should accept the offer of overtime at three times the
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 normal rate. (6 marks)
(d) Calculate the new optimum production plan if maximum demand for W falls to 200
units. (4 marks)
(20 marks)
(ACCA F5 Performance Management June 2010 Q3)

Question 5
The Cosmetic Co is a company producing a variety of cosmetic creams and lotions. The
creams and lotions are sold to a variety of retailers at a price of $23·20 for each jar of face
cream and $16·80 for each bottle of body lotion. Each of the products has a variety of
ingredients, with the key ones being silk powder, silk amino acids and aloe vera. Six months
ago, silk worms were attacked by disease causing a huge reduction in the availability of silk
powder and silk amino acids. The Cosmetic Co had to dramatically reduce production and
make part of its workforce, which it had trained over a number of years, redundant.

The company now wants to increase production again by ensuring that it uses the limited
ingredients available to maximise profits by selling the optimum mix of creams and lotions.
Due to the redundancies made earlier in the year, supply of skilled labour is now limited in the
short-term to 160 hours (9,600 minutes) per week, although unskilled labour is unlimited. The
purchasing manager is confident that they can obtain 5,000 grams of silk powder and 1,600
grams of silk amino acids per week. All other ingredients are unlimited. The following
information is available for the two products:

Cream Lotion
Materials required: silk power (at $2.20 per gram) 3 grams 2 grams
– silk amino acids (at $0.80 per gram) 1 gram 0.5 grams
– aloe vera (at $1.40 per gram) 4 grams 2 grams
Labour required: skilled ($12 per hour) 4 minutes 5 minutes
– unskilled (at $8 per hour) 3 minutes 1.5 minutes

Each jar of cream sold generates a contribution of $9 per unit, whilst each bottle of lotion
generates a contribution of $8 per unit. The maximum demand for lotions is 2,000 bottles per
week, although demand for creams is unlimited. Fixed costs total $1,800 per week. The
company does not keep inventory although if a product is partially complete at the end of one
week, its production will be completed in the following week.

Required:

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(a) On the graph paper provided, use linear programming to calculate the optimum number
of each product that the Cosmetic Co should make per week, assuming that it wishes to
maximise contribution. Calculate the total contribution per week for the new production
plan. All workings MUST be rounded to 2 decimal places. (14 marks)
(b) Calculate the shadow price for silk powder and the slack for silk amino acids. All
workings MUST be rounded to 2 decimal places. (6 marks)
(20 marks)
(ACCA F5 Performance Management December 2010 Q3)

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III. Pricing Decisions

Question 6
Heat Co specialises in the production of a range of air conditioning appliances for industrial
premises. It is about to launch a new product, the ‘Energy Buster’, a unique air conditioning
unit which is capable of providing unprecedented levels of air conditioning using a minimal
amount of electricity. The technology used in the Energy Buster is unique so Heat Co has
patented it so that no competitors can enter the market for two years. The company’s
development costs have been high and it is expected that the product will only have a five-
year life cycle.

Heat Co is now trying to ascertain the best pricing policy that they should adopt for the
Energy Buster’s launch onto the market. Demand is very responsive to price changes and
research has established that, for every $15 increase in price, demand would be expected to
fall by 1,000 units. If the company set the price at $735, only 1,000 units would be demanded.

The costs of producing each air conditioning unit are as follows:

$
Direct materials 42
Labour 12 (1.5 hours at $8 per hour. See note below)
Fixed overheads 6
Total cost 60

Note
The first air conditioning unit took 1·5 hours to make and labour cost $8 per hour. A 95%
learning curve exists, in relation to production of the unit, although the learning curve is
expected to finish after making 100 units. Heat Co’s management have said that any pricing
decisions about the Energy Buster should be based on the time it takes to make the 100th unit
of the product. You have been told that the learning co-efficient, b = –0·0740005.

All other costs are expected to remain the same up to the maximum demand levels.

Required:

(a) (i) Establish the demand function (equation) for air conditioning units; (3 marks)
(ii) Calculate the marginal cost for each air conditioning unit after adjusting the labour
cost as required by the note above; (6 marks)

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 (iii) Equate marginal cost and marginal revenue in order to calculate the optimum price
and quantity. (3 marks)
(b) Explain what is meant by a ‘penetration pricing’ strategy and a ‘market skimming’
strategy and discuss whether either strategy might be suitable for Heat Co when
launching the Energy Buster. (8 marks)
(20 marks)
(ACCA F5 Performance Management June 2011 Q2)

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IV. Dealing with Risk and Uncertainty in Decision-Making

Question 7 – Pricing and purchase contract decisions based on uncertain demand and
calculation of maximum price to pay for perfect information
Z Ltd is considering various product pricing and material purchasing options with regard to a
new product it has in development. Estimates of demand and costs are as follows:

If selling price per unit is £15 per unit £20 per unit
Sales volume Sales volume
Forecasts Probability (000 units) (000 units)
Optimistic 0.3 36 28
Most likely 0.5 28 23
Pessimistic 0.2 18 13
Variable manufacturing costs
(excluding materials) per unit £3 £3
Advertising and selling costs £25,000 £96,000
General fixed costs £40,000 £40,000

Each unit requires 3kg of material and because of storage problems any unused material must
be sold at £1 per kg. The sole suppliers of the material offer three purchase options, which
must be decided at the outset, as follows:

(i) any quantity at £3 per kg, or

(ii) a price of £2.75 per kg for a minimum quantity of 50 000 kg, or
(iii) a price of £2.50 per kg for a minimum quantity of 70 000 kg.

You are required, assuming that the company is risk neutral, to

(a) prepare calculations to show what pricing and purchasing decisions the company should
make, clearly indicating the recommended decisions; (15 marks)

(b) calculate the maximum price you would pay for perfect information as to whether the
demand would be optimistic or most likely pessimistic. (5 marks)
(Total 20 marks)

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Question 8 – Selling price decision based on expected values and value of additional
information
Warren Ltd is to produce a new product in a short-term venture which will utilize some
obsolete materials and expected spare capacity. The new product will be advertised in quarter
I with production and sales taking price in quarter II. No further production or sales are
anticipated.

Sales volumes are uncertain but will, to some extent, be a function of sales price. The possible
sales volumes and the advertising costs associated with each potential sales price are as
follows:

The resources used in the production of each unit of the product are:
Production labour: Grade 1 2 hours
Grade 2 1 hour
Materials: X 1 unit
Y 2 units

The normal cost per hour of labour is:

Grade 1 £2
Grade 2 £3

However, before considering the effects of the current venture, there is expected to be 4,000
hours of idle time for each grade of labour in quarter II. Idle time is paid at the normal rates.

Material X is in stock at a book value of £8 per unit, but is widely used within the firm and
any usage for the purposes of this venture will require replacing. Replacement cost is £9 per
unit.
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Material Y is obsolete stock. There are 16,000 units in stock at a book value of £3.50 per unit
and any stock not used will have to be disposed of at a cost, to Warren, of £2 per unit. Further
quantities of Y can be purchased for £4 per unit.

Overhead recovery rates are:

Variable overhead £2 per direct labour hour worked
Fixed overhead £3 per direct labour hour worked

Total fixed overheads will not alter as a result of the current venture.

Feedback from advertising will enable the exact demand to be determined at the end of
quarter I and production in quarter II will be set to equal that demand. However, it is
necessary to decide now on the sales price in order that it can be incorporated into the
advertising campaign.

Required:

(a) Calculate the expected money value of the venture at each sales price and on the basis
of this advise Warren of its best course of action. (12 marks)
(b) Briefly explain why the management of Warren might rationally reject the sales price
leading to the highest expected money value and prefer one of the other sales prices.
(4 marks)
(c) It will be possible, for the sales price of £40 per unit only, to ascertain which of the four
levels of demand will eventuate. If the indications are that the demand will be low then
the advertising campaign can be cancelled at a cost of £10,000 but it would then not be
possible to continue the venture at another sales price. This accurate information
concerning demand will cost £5,000 to obtain.

Indicate whether it is worthwhile obtaining the information and ascertain whether it

would alter the advice given in (a) above. (4 marks)
(Total 20 marks)
(ACCA Level 2 Management Accounting)

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